1. The quotation contains several serious errors. First, concern with health care costs does not mean that health care is not a “good.” Economists do not care about the cost of health care per se. Rather, the issue is whether there are distortions in the market that lead to more than an efficient amount being consumed. Second, it makes a lot of difference how money is spent. One can create employment by hiring people to dig ditches and then fill them up, but this produces nothing useful in the way of goods and services. Thus, employment in the health care sector is not desirable in itself. It is desirable to the extent that it is associated with the production of an efficient quantity of health care services.
2. a. Those who have a relatively high probability of needing the insurance are the ones who are most likely to buy it. This raises the premium, which in turn, leads to selection by people who have an even higher probability of using it. The cycle continues until the price is so high that virtually no one purchases the policy.
b. Employer-provided health insurance is deductible to the employer and not taxed to the employee.
c. Because of the tax subsidy, individuals may purchase more than the efficient amount of health insurance. That is, they “over-insure.” An interesting example of how the tax system leads to overinsurance is given in a recent Wall Street Journal (January 19, 2004) article by Martin Feldstein. He gives an example of two different California Blue Cross health plans – identical in all respects except for the deductible and annual premiums. The low-deductible plan (the “generous”
plan) has a deductible of $500 per family member, up to a maximum of two and an annual premium of $8,460. Thus, the maximum out-of-pocket expense is
$1,000. The high-deductible plan (the “less generous” plan) has a deductible of
$2,500 per family member, up to a maximum of two, and an annual premium of
$3,936. Thus, the maximum out-of-pocket expense is $5,000. Note that the premium savings of $4,524 actually exceeds the maximum incremental deductible payment of $4,000 (which would only occur if the family had very high health expenses). In principle, the high deductible plan is unambiguously better. But the traditional tax rules could lead an employer to choose the low deductible policy.
If the employee faced a marginal tax rate of 45% (the sum of federal, state, and payroll tax rates), then if the $4,524 premium saving was turned into taxable salary, the individual’s net income would only rise by $2,488. Thus, families with high expected medical expenses do better with the “generous” plan, even though it is more costly in terms of premiums.
3. a. Dd=4.22–(0.044)(50)=2 visits per year.
Total expenditure =(2)(50)=$100
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b. Now the individual pays only $5 per visit.
Dd = 4.22 – (0.044)(5) = 4 visits, with out-of-pocket costs of $20.
Insurance company pays ($45)(4) = $180
Total expenditure = $200, double its previous level.
4. Examining Figure 10.1, we can see why health care costs increased for the state of Tennessee. As insurance coverage increases, this lowers the cost of medical expenses for those who were previously did not have insurance, which increases the overall amount of medical services they consume. Before receiving insurance, these people demand Mo
units of medical services, and the amount they pay is represented by the area OPoaMo. But after receiving insurance coverage, they demand M1 amounts of medical services, paying only OjhM1, while their insurance pays jPobh. The increase in insurance payments is sizable for two reasons – first, by providing coverage, it pays for the majority of the already sizable medical expenses incurred by this group, and second, the introduction of insurance makes the group consume even more medical services. In short, if the people who designed the Tennessee program had realized that the demand curve for medical services is downward sloping, they would not have been surprised at the consequences of their program.
To explain why HMOs have been unable to contain long-run health care costs, it is necessary to consider the effect of technology on health care costs in the long-term. The inherent problem is that the market for medical care places a large premium on using the latest and most-developed medicines and machinery for treating patients. These technologies tend to be expensive. Hence, while introducing HMOs can lead to a once and for all decrease in the rate of change in health care costs, there is nothing that an HMO can do to lower the cost of continually providing the latest in medical treatments.
5. The goal of making the Medicare prescription drug benefit a one-time, permanent decision is to reduce the adverse selection problem (note: the current “Medigap”
program operates in this manner to some extent – a senior citizen has choice over all 10 of the Medigap plans for only a short period of time after they turn 65, after which they may be denied based on their health). Imagine a cohort of people turning age 65 and becoming eligible for the Medicare drug benefit. If the decision to enter (or exit) could be made every year, then healthy senior citizens would have a strong incentive to wait until they became unhealthy and needed drugs, and then enter the prescription drug program (presumably resulting in economic losses for the program). Similarly, when people who were collecting the prescription drug benefit became healthy, they would have a strong incentive to “opt-out” of the program. By making the decision opt-in at the beginning or not at all, the healthy younger seniors are likely initially cross-subsidizing the older seniors. Note that this “opt-in at the beginning” works because bad health and older age are positively correlated with each other. If, for example, younger seniors used more drugs (and perhaps older seniors used more inpatient care, etc.), then older seniors could simply stop paying annual premiums and give up their option of being in the program. If this scenario held empirically, this would exacerbate the adverse selection problem and the opt-in scenario would not completely solve the adverse selection problem.
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6. The budget constraint initially has units of Medigap on the x-axis, and other goods on the y-axis. Given initial prices of $1 per unit for each good, and $30,000 of income, the budget constraint has a slope of -1, and the intercepts on both axes are at 30,000 units. It is assumed that the initial utility maximizing bundle consumes 5,000 units of Medigap, hence the indifference curve is tangent at (5000,25000). All of this is illustrated in the figure below.
U0 Other Goods
Medigap efficiency units FIGURE 10.6a – Medigap choice without
minimum standards
30,000 30,000
5,000 25,000
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After the “minimum Medigap” mandate, the consumer can either choose 0 units of Medigap or 8,000 or more units of Medigap. Thus, part of the budget constraint is eliminated (though the overall shape remains the same as before). After the mandate, the point (0,30000) is available, as well as all of the points to the southeast of the point (8000,22000). Clearly, the person’s utility must fall since the preferred choice, (5000,25000) is no longer available. If the person attains a higher level of utility as (0,30000) compared with (8000,22000), the person chooses to not purchase Medigap. In this case, the marginal rate of substitution is no longer equal to the price ratio. This is illustrated below.
U1 U0 Other Goods
Medigap efficiency units FIGURE 10.6b – Medigap choice with
minimum standards; no Medigap is purchased
30,000 30,000
5,000 25,000
8,000 22,000
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7. a. The gross price of insurance is $2, but since insurance is bought with pre-tax dollars, the effective price of insurance is (1-t)P, where t is the marginal tax rate.
Since Connor’s marginal tax rate is 25%, the effective price of insurance is lower, only (1-.25)*$2, or $1.50 per unit. At $1.50 per unit, and using the demand curve of Q=100-8P, this implies that Connor buys Q=100-8($1.50)=88 units of insurance.
b. If insurance is no longer excluded from taxation, the effective price rises to $2 per unit. In this case, Connor buys Q=100-8($2)=84 units of insurance.
c. The exclusion of health insurance from taxation lowers its effective price – as long as the demand for health insurance slopes downward, then lower prices lead to higher demand for insurance. This can be viewed as “over-consumption” if the assumptions of the First Fundamental Welfare Theorem hold, which suggests that the private market allocation without subsidies or taxes yields the Pareto efficient allocation. On the other hand, there may be (weak) reasons based on the Fundamental Welfare theorem, there should be a tax subsidy for health insurance.
The main reason would probably be if we thought that health insurance had positive externalities, which might be possible with communicable diseases.
There are other reasons why government intervention may be warranted in health insurance markets (e.g., asymmetric information), but it is not obvious that these reasons lead to the tax subsidy we observe in the U.S.